A financial instrument trading system, such as a futures exchange, referred to herein also as an “Exchange”, such as the Chicago Mercantile Exchange Inc. (CME), provides a contract market where financial instruments, for example futures and options on futures, are traded. Futures is a term used to designate all contracts for the purchase or sale of financial instruments or physical commodities for future delivery or cash settlement on a commodity futures exchange. A futures contract is a legally binding agreement to buy or sell a commodity at a specified price at a predetermined future time. An option is the right, but not the obligation, to sell or buy the underlying instrument (in this case, a futures contract) at a specified price within a specified time. The commodity to be delivered in fulfillment of the contract, or alternatively the commodity for which the cash market price shall determine the final settlement price of the futures contract, is known as the contract's underlying reference or “underlier.” The terms and conditions of each futures contract are standardized as to the specification of the contract's underlying reference commodity, the quality of such commodity, quantity, delivery date, and means of contract settlement.
Typically, the Exchange provides for a centralized “clearing house” through which all trades made must be confirmed, matched, and settled each day until offset or delivered. The clearing house is an adjunct to the Exchange, and may be an operating division of the Exchange, which is responsible for settling trading accounts, clearing trades, collecting and maintaining performance bond funds, regulating delivery, and reporting trading data. The essential role of the clearing house is to mitigate credit risk. Clearing is the procedure through which the Clearing House becomes buyer to each seller of a futures contract, and seller to each buyer, also referred to as a novation, and assumes responsibility for protecting buyers and sellers from financial loss due to breach of contract, by assuring performance on each contract. A clearing member is a firm qualified to clear trades through the Clearing House.
Although futures contracts generally confer an obligation to deliver an underlying asset on a specified delivery date, the actual underlying asset need not ever change hands. Instead, futures contracts may be settled in cash such that to settle a future, the difference between a market price and a contract price is paid by one investor to the other. Cash Settlement is a method of settling a futures contract whereby the parties effect final settlement when the contract expires by paying/receiving the loss/gain related to the contract in cash, rather than by effecting physical sale and purchase of the underlying reference commodity at a price determined by the futures contract price.
By employing cash settlement, futures may be based on more abstract market indicators, such as stock indices, interest rates, futures contracts and other derivatives. Rather than requiring the delivery of a market index (a concept that has no real meaning), or delivery of the individual components that make up the index, at a set price on a given date, index futures can be settled in cash. The difference between the contract price and the price of the underlying asset (i.e., current value of market index) is exchanged between the investors to settle the contract.
Traders frequently trade multiple futures contracts rather than focus on any single futures contract. In a typical futures trading environment, traders enter into a “spread” between two distinct, yet similar contracts by buying or going long in one contract and selling or going short in another contract. A trader may enter into a “calendar” or “intra-market spread” by buying and selling two futures contracts in the same market but in different contract months, such as the purchase of a March Eurodollar futures contract coupled with the sale of a September Eurodollar futures contract. A trader may enter into an “inter-market” spread by buying and selling two futures contracts in different markets, such as the purchase of a 5-year Treasury note futures contract coupled with the sale of a 10-year Treasury note futures contract.
A trader may “leg into” spreads by entering two separate orders for the long and short portions of the spread. Frequently, however, spread trading is accommodated by directly listing a spread on the exchange so that the spread may be executed at a singular price without legging into the two sides of the spread separately. Once a transaction price for the spread is established, the exchange thereupon books the two separate legs of the spread separately.
More complex spreads or “combination trades” are also commonplace. A “butterfly” spread entails the execution of transactions across three different contract months in a particular futures contract. For example, a trader may buy one March Eurodollar futures, sell two June Eurodollar futures and buy one September Eurodollar futures.
Option contracts are particularly conducive to complex combinations of transactions spread across puts and calls; strike prices as well as expiration dates. For example, a trader may enter into a vertical bull call spread by buying a low-struck Euro-US dollar call and selling a high-struck Euro-US dollar call, with the same expiration data. Frequently, option combinations may involve two, three, four or more different options.
“Packs” and “bundles” of Eurodollar option contracts may be traded with the use of a singular order traded at a singular price. For example, a 2-year bundle may be executed by buying (or selling) the first eight quarterly expiring Eurodollar futures.
In many cases, the exchange will list such complex or combination spreads or transactions just as the exchange may list calendar and inter-market spreads that may be traded directly as a singular order. The exchange may apply an algorithm to determine the price of the individual legs of the spread once the transaction is concluded at a singular price or price differential.
The exchange may limit its listings of complex or combination spreads to the more popular or frequently traded of such transactions. Traders interested in more complicated orders that are not listed on the exchange may be compelled to “leg-into” the trade by executing each individual leg separately. But the process of legging into the spread entails risk to the extent that one may be unable to execute one or more legs, or that prices fluctuate adversely after one has already executed one or more leg(s) of the transaction and before one has concluded the other legs. In the latter case, the trader thus incurs a loss relative to the original spread price to complete the spread trade.